Accounting Rate of Return - ARR

  

Categories: Bonds, Accounting

Accounting Rate of Return (or ARR, just like a pirate, matey) is the amount of profit (also known as return) you can expect to make on an investment.

You can use the ARR to compare investments and see which one will make you the most moolah over time. ARR is pretty basic, and it does not take inflation into consideration, so it's up to you to keep in mind that, if you're making $100 a year from an investment, the $100 you earn this year is going to be worth a lot more than the $100 you earn on that same investment ten years from now.

Related or Semi-related Video

Finance: What are Return on Equity and R...145 Views

00:00

finance a la shmoop. what are return on equity and return on assets? all right

00:09

return on equity ROE .what is it? and no it's not that stuff that they stick on [sushi on a plate]

00:15

the outside of sushi. it's the kissing cousin of ROA if that helps. so what

00:20

is return then in this instance huh? well it's just profits. and there's a broader

00:24

frame here to think about. if your company just made five million dollars

00:27

in profits, was that good bad middlin? well if you were a little lemonade stand

00:32

that took 50 grand to start last year and you've made this massive five

00:37

million dollar haul well then yeah wow that's awesome. but if you're Google and

00:41

this year you only made five million bucks well you have tens of billions of

00:45

dollars of capital out there trying to earn lots more while making only five

00:50

million was a huge fail. so these concepts revolve around the balance

00:54

sheet remember this thing well here are assets, and if your General Electric the [balance sheet shown]

00:58

asset side is enormous. say with the notional fifty billion dollars in assets

01:03

if you made a ten percent return on your assets or raw ROA

01:09

return on assets well that would mean you netted five billion dollars right?

01:13

ten percent of 50 billions five billion. your return on assets was ten percent [math equation shown]

01:17

there. so remember equity or shareholders equity or retained equity on the balance

01:22

sheet yeah this thing right here what equity is the retained profits after

01:26

you've started to build your company and after years and years of building your

01:29

company you would expect to have a lot of retained earnings. so what were the

01:33

returns on that equity or ROE only returns or profits number is the same as

01:39

it was in the ROA calculation only now in the denominator we have equity so if

01:44

your returns were say five billion and your retained equity was twenty billion [equations shown]

01:48

well you had a lovely twenty five percent return this year. twenty five

01:52

percent of twenty billion you know five billion. meaning that in just this one

01:56

year you grew your retained equity one massively. you've become a big harvester [man lifts weights]

02:01

of cash profits from whatever great business it is that you built. well why

02:06

do we care about ROA and ROE? well because capital efficiency

02:11

matters. it's a reflection of how efficient you are, how well you're

02:14

investing your capital how will you're able to grow the business. that is in

02:18

theory you could just sell your assets and go invest them elsewhere, like go

02:22

play an index fund in the stock market, and potentially return better profits

02:26

for your shareholders, and if you can do that well then you're probably going to

02:30

get fired. and there is precedent for this change .the airline industry there [airplane taking off]

02:37

was a time when American Airlines and United Airlines and crash Airlines owned

02:43

all their airplanes. they bought them at 50 million bucks a pop give or take but

02:47

the airline industry is a lousy business producing very low cash profits. every

02:52

time the economic cycle is good the economy is good people are buying

02:56

airline tickets up the wazoo, the Union strike and the airline's try to do

03:00

stupid things with pricing and a bunch of other things happen and all the

03:03

profits go away. anyway so one day a smart MBA employed by the airline said

03:09

hey dudes why don't we just lease the airplanes from Boeing or whoever makes [man speaks to group]

03:14

them and we only need a fraction of our assets or equity or capital to produce

03:18

about the same investment returns for our shareholders. yeah and that's what

03:22

they did. so most airlines these days don't own

03:24

their own planes they lease them from the manufacturer or others and well

03:29

there haven't been any airline bankruptcies lately. and yes the airline

03:33

industry hard to find a better success story. [plane takes off]

Up Next

Finance: What Is a Real Return?
67 Views

What is real return? Real return is the actual return made from an investment after inflation is factored in. Return is expressed as a percentage c...

Finance: How Do You Calculate Rates of Return?
35 Views

How do you calculate rates of return? Calculating rate of return on an investment that pays dividends can be a bit tricky. You need to look at the...

Finance: What is Hurdle Rate?
62 Views

One of the toughest jobs any head coach for the NFL or NBA has is: who makes the final team roster? Is there a level of production that warrants th...

Find other enlightening terms in Shmoop Finance Genius Bar(f)